By Frederick Z. Lodge, Robert E. Michael and Christopher S. Dewees

Among the lessons real property secured lenders learned during the recent real estate recession is that a borrower's bankruptcy can severely impair a lender's ability not only to realize its projected yield on a loan but also to realize on the security for the loan. Foreclosures, which can take a few months to a few years to complete, are delayed if not totally supplanted by the borrower's bankruptcy. Notwithstanding a lender's security interest, a bankrupt borrower is often permitted to use (and, hence, diminish) a lender's collateral during the bankruptcy. Moreover, in some cases, a bankrupt borrower can "cram down" a secured lender through a reorganization plan, freezing the lender's position for years at low interest rates and reduced security.

Although the bankruptcy risk is serious enough for lenders providing new senior financing, the risk invariably increases when a lender provides subordinate financing or extends financing in a workout. Without bankruptcy risk planning, otherwise acceptable financing proposals may flounder. Unfortunately, unlike most identified risks in a financing, the bankruptcy risk cannot be addressed contractually. Although a bankruptcy filing typically is a breach of the loan documents, these provisions do not prevent the borrower from proceeding under the bankruptcy laws.

Recently, lenders have added covenants to new credit and workout agreements that purport to give the lender control over the actions of the borrower and the disposition of the lender's collateral in a bankruptcy proceeding. The appellate courts that have considered these covenants, however, have found them to violate public policy, although a smattering of bankruptcy judges have given them at lease some effect. See, e.g., Farm Credit v. Polk, 160 B.R. 870 (M.D. Fla. 1993); In re Jenkins Court Assocs. Ltd. Partnership, 181 B.R. 33 (Bankr. E.D. Pa. 1995). But see In re Club Tower L.P., 138 B.R. 307 (Bankr. N.D. Ga. 1991); In re Citadel Properties, Inc., 86 B.R. 275 (Bankr. M.D. Fla. 1988).

Without the ability to enforce lender-friendly bankruptcy control provisions in their loan documents, lenders and their lawyers have sought ways to improve the efficacy of security interests in bankruptcy. Sophisticated lenders are addressing the issue indirectly by requiring "bankruptcy remote" structures for transactions. These structures are designed to make a bankruptcy filing less likely or more distasteful for the borrower and its principals. The structures are increasingly a part of traditional commercial real estate financing transactions. Moreover, the recent popularity of securitization as an alternative to traditional financing has increased the usefulness of bankruptcy remote structuring.

Bankruptcy Remote Options

The function of any bankruptcy remote structure is to reduce one or both of the following risks: (1) the risk that the borrower will file a voluntary bankruptcy petition; and (2) the risk that creditors of the borrower or its affiliates will force the borrower into involuntary bankruptcy,, either individually or as the result of a consolidation with an affiliate's bankruptcy. Lenders have several options to minimize, but not eliminate, these risks. These options offer a menu of choices to lenders, some or all of which may be selected, depending on the nature and complexity of the transaction and the parties involved. These options include the following features:

  • Single Purpose Borrower. The most common method to minimize the bankruptcy risk is the use of a single asset, single purpose borrower. A single purpose borrower's sole asset is the property securing the loan and its sole purpose is to own and manage the property. Apart from the lender's loan and ordinary course-of-business trade debt, the loan documents typically prohibit the borrower from incurring significant additional debt. If subordinate debt is permitted, the rights and obligations of the senior and junior lenders should be set forth in an intercreditor agreement that dictates each lender's respective rights and obligations in the event of the borrower's default or bankruptcy.

    Recent amendments to the bankruptcy code have made single purpose borrowers more attractive to lenders in smaller financings. Accelerated bankruptcy proceedings are now prescribed for certain single asset real estate companies that have incurred no more than $4 million in real property secured debt. Nevertheless, the use of a single purpose borrower, by itself, will not prevent a voluntary bankruptcy filing or preclude the borrowing entity from being consolidated into an affiliate's bankruptcy. Also, if the financed property is transferred to the single purpose entity after the initial loan funding (for example, in a workout), the transfer may be deemed fraudulent under a variety of laws that do not require proof of fraudulent intent. Consequently, the single purpose entity option is a preferred (if not standard) bankruptcy remote practice in any financing. In workouts and in larger, more complex financings, it serves as a starting point for use with other alternatives discussed below.

  • Entity Controls. Fundamental to many bankruptcy remote structured transactions are various entity controls designed to prevent those with decision making authority for the borrower from electing bankruptcy or, from the lender's perspective, other undesired courses of action. The form and extent of entity controls depends on the structure of the borrower and its affiliates, the size and nature of the transaction, the amount of control the lender desires and the lender's appetite for lender liability risk.. Yet all entity control bankruptcy remote structures have a common function - to make certain actions, including the filing of a voluntary bankruptcy petition, beyond the borrower's authority without the prior consent of someone controlled by,, or at least influenced by, the lender. Consequently, a voluntary bankruptcy petition is no longer just a default under the loan documents; in addition, the borrower may not, as a matter of its internal governance, file a petition in the first place.
  • Although the details of any control structure vary greatly from transaction to transaction, each has two basic facets. First, someone proposed by (and often affiliated with) the lender is introduced into the borrower's ownership structure at the appropriate level (for example, as a shareholder of the general partner of the borrower), with approval authority for certain specified actions considered to have a high bankruptcy risk. Second, the applicable entity formation documents are drafted so that specified bankruptcy sensitive actions require the consent of all partners, shareholders, members or directors, as applicable (including, of course, the lender's designee).

    The way in which the lender's designee is introduced into the borrower's structure may vary. Most simply, a person designated by the lender is added to the governing body of the borrower or its general partner or other controlling constituent entity. The lender's designee will have the sole authority (or at least a veto right) over the restricted actions identified in the formation documents. To minimize lender liability risks, the lender or its parent may create a new, wholly owned entity with the sole task of serving as the lender's designee.

    Concurrently with the introduction of the lender's designee into the borrower's structure, modifications are made to the borrower's formation documents to restrict the actions that may be taken without the lender's designee's consent. These restrictions typically include limitations on the borrower's ability to (1) file a voluntary bankruptcy petition; and (2) take actions that could cause a third party to file an involuntary bankruptcy petition against the borrower. Some of the restrictions are obvious, such as prohibiting the borrower or entity controlling the borrower from filing a voluntary bankruptcy petition on the borrower's behalf. Others are more subtle - for example, prohibiting the borrower from incurring additional debt or making distributions to its owners. When listing restrictions, the document drafter should take care to balance the lender's desire to minimize bankruptcy risks against the practicalities of the lender's involvement in property administration and the risks of lender liability and equitable subordination.

    In all cases, the entity control structure should be individually crafted to suit the ownership structure of the borrower and the level of control desired. Often, controls are appropriately imposed on more than one entity in the borrower's structure. Before determining the particular controls required for a specific transaction, lender's counsel should perform a thorough analysis of the borrower's ownership. Counsel should note that the bankruptcy code authorizes any general partner to file an involuntary petition in bankruptcy against its partnership even when the relevant partnership agreement does not permit its general partners to file a voluntary petition on behalf of the partnership. 11 U.S.C. - 303. Thus, if the borrower is a limited partnership, it may be desirable to include a lender designee as both a new general partner in the borrower and as a new shareholder in the borrower's general partner, with appropriate restrictions in the formation documents at both levels.

    Despite the benefits of a properly designed control structure, the protections it affords must be weighed against the lender liability risks of possessing or exercising control rights in the borrower. The lender also runs the risk of having a bankruptcy court find it an "insider" of the borrower, extending the bankruptcy preference period applicable to payments made by the borrower to the lender to one year. 11 U.S.C. 101(31)(C)(v).

  • Voting Trust. To limit the lender liability risks attendant to an entity control structure, lenders may consider using a voting trust, instead of a lender designee, as the decision making authority for the borrower concerning bankruptcy sensitive actions. Generally, after the lender has established a satisfactory entity control structure, the lender requires the borrower to establish a voting trust with an independent third party under a voting trust agreement among the borrower (and any other entity controlling the borrower), the shareholder, partners or members of the borrower and the independent voting trustee.

    Under the voting trust agreement, the relevant shareholders, partners or members transfer all or a portion of their voting interests to the trustee, which holds those interests in trust in accordance with the voting trust agreement. When a proposed action (other than the specified bankruptcy risk actions) requires the owners' approval, the voting trust agreement requires the trustee to act in accordance with the wishes of the depositing trustor. For specified bankruptcy risk actions, the trustee must act in accordance with the wishes of a designated group of the borrower's creditors, often the major creditors. Typically, the lender is a third party beneficiary of the trustee's rights under the voting trust agreement. On repayment of the loan, the voting trust terminates.

    Although a voting trust arrangement adds an additional layer of complexity to the entity control structure by interposing an ostensibly independent trustee between the lender and the borrower, a voting trust may afford the lender additional protection against lender liability claims. The lender has no direct decision making authority because the trustee makes all bankruptcy risk decisions. Moreover, the trustee is required to act not in accordance with the lender's instructions but in accordance with the wishes of the borrower's major creditors. Of course, the lender is usually the sole major creditor. The main problem with this option is inherent in its nature as a trust. If the trustee is truly without discretion, there is a risk that the voting trust may be deemed illusory under state law. Also, any dispute over trust related issues may be relegated to commercially unsophisticated state probate or surrogate courts.

  • Limited Recourse Guaranty. Perhaps the most effective of all bankruptcy remote options is a limited recourse guaranty (often referred to as a "springing" guaranty), executed and delivered by the appropriate solvent persons or entities controlling the borrower. Unlike an ordinary guaranty, which may be difficult to negotiate and obtain from a borrower's principals, a limited recourse guaranty is enforceable ("springing" into existence) only on the occurrence of the borrower's bankruptcy or other specified undesirable events caused by the borrower, its principals or their affiliates. These events typically include any action by the borrower or its principals to frustrate or delay the lender's exercise of its remedies on default, including the assertion of counter-claims or defenses in enforcement actions. Consequently, even if the borrower is in default under its payment obligations, the lender may not enforce the guaranty so long as the borrower does not file a voluntary bankruptcy petition or to delay the lender's exercise of its remedies.
    In addition to its simplicity, the chief advantage of a limited recourse guaranty is that it does not purport to prevent a bankruptcy filing. Instead, it makes a bankruptcy filing or any other remedy-delaying tactics hazardous to those with the ability to control them. The limited recourse guaranty approach has been rendered even more attractive by recent amendments to the bankruptcy code designed to eliminate extended preference periods associated with guaranteed debt.. This problem arose from Levit v. Ingersoll Rand Fin. Corp., 874 F.2d 1186 (7th Cir. 1989) (commonly known as Deprizio), which extended to one year the 90 day voidable preference period under 11 U.S.C. 547 to all transfers (including loan repayments) by a borrower to a lender when the loan is guaranteed by an insider of the borrower.

    As with any guaranty, the value of a limited recourse guaranty depends on the solvency and wealth of the guarantor and the availability of this wealth when needed to satisfy the guaranteed obligation. In addition, the limited recourse nature of the guaranty often does not mollify hesitant principals that may be unwilling to provide any guaranty (limited or otherwise) in the context of traditional non-recourse financing.

  • Lockbox. A more traditional method of discouraging borrower bankruptcies is the lockbox. Most real estate secured loans include a collateral assignment by the borrower to the lender of the rents and profits of the real estate. When the borrower defaults, the lender, depending on the jurisdiction, may be able to have a receiver appointed and take possession of the rents and profits. Until this happens, the assignment of rents alone does not prevent the borrower from diverting the rents and profits from their agreed uses (such as debt service and property maintenance). A borrower sensing an impending bankruptcy may divert the funds to prevent them from becoming "cash collateral" in bankruptcy and potentially available to the lender. One purpose of this diversion may be to create a "war chest" to fund the imminent bankruptcy proceeding.

    A lockbox structure is intended to address this problem. Conceptually simple but often difficult to negotiate and administer, this option requires the borrower to cause all property finances to be administered through a central clearinghouse generally consisting of two parts: a lockbox(usually maintained with a third party) into which all rent checks and other payments and all invoices and receipts are deposited; and a bank account (usually maintained with a third party bank) through which all property cash flow is funneled. The lender has a security interest in the lockbox and the account. Managed in conjunction with the project budget, the lockbox permits the lender to observe and to exercise some control over the financial operations of the property. Richard D. Jones and Adam F. Zweifler, Locking Up the Cash in Workouts, 9 Prob. & Prop. 17 (July/Aug. 1995).

    A lockbox structure allows a lender to prevent the borrower from diverting property cash flow. It also enables the lender to monitor constantly all property creditors. Combined with appropriate rights in the loan documents, a lockbox may permit the lender to reduce the risk that a property creditor could commence an involuntary bankruptcy filing against the borrower.

    One of the principal disadvantages of the lockbox is the difficulty and administrative cost. Vendors and tenants often ignore directions to submit invoices and payments to the lockbox. Often the lender does not have the time or the desire to police the functioning of the lockbox structure. Another disadvantage is the potential to subject an actively involved lender to lender liability lawsuits arising from the lender's perceived control over the property's operations. This option is most effective when combined with the entity and voting trust structures discussed above.

Bankruptcy Remote Structures in Securitizations.

The capita markets have found an additional use for bankruptcy remote structures. Bankruptcy remote structures have been used to improve the credit rating of a securities offeror. IN fact, in connection with certain securitizations, credit rating agencies have required that transactions be structured in a bankruptcy remote manner as a rating prerequisite. See, e.g., Standard & Poor's, Structured Finance Ratings Real Estate Finance (Legal and Structured Finance Issues in Commercial Mortgage Securities) ch. 4 (1995).

Lender Liability Risks and Other Caveats

The use of certain bankruptcy remote features in real estate financing - particularly entity control structures - increases the risk that the lender will incur liability for the actions its borrower. To the extent the lender acquires the ability to control the borrower's operations, it may be liable for the exercise of this control. If the lender's designee is a general partner in the borrower, the lender's designee is vicariously liable for the debts and obligations of the partnership. Similarly, as a general partner, member, shareholder or director of the borrower, the lender's designee may owe fiduciary duties to the other partners, members, shareholders or directors and, in certain cases, to the creditors of the borrower. The lender's designee may breach these duties if it acts in the interests of the lender.

The fiduciary duty issue is perhaps most pronounced when it is clear that a voluntary bankruptcy filing is in the borrower's best interests but is undesirable to the lender. Ultimately, a large enough share in the control of the borrower's affairs, combined with certain features of the financing (e.g., a shared appreciation feature) could cause the lender to be deemed a partner of or joint venturer with the borrower and could convert the financing into an equity interest. In addition, if the borrower is a limited partnership and the designee is a limited partner, the lender's designee risks losing its limited liability status by exercising control rights. This concern does not apply if the borrower is a corporation or limited liability company.

Also, under certain circumstances, a bankruptcy court may "equitably subordinate" a lender's claim to that of other creditors. Bankruptcy courts generally apply a three part test to determine whether a lender's claim should equitably subordinated: (1) whether the lender has control over the conduct of the borrower's affairs; (2) whether the lender exercised this control to the lender's benefit; and (3) whether this exercise of control detrimentally affected other creditors of the borrower. See, e.g., Khan & Nate's Shoes No. 2, Inc. v. First Bank of Whiting, 908 F.2d 1351, 1356 (7th Cir. 1990), citing Benjamin v. Diamond, 563 F.2d 692 (5th Cir.1977). However, if the property's value has sunk well below the amount of the loan, this risk will be minimal because most other creditors will have been economically disenfranchised. In general, there is a direct tradeoff between the effectiveness of the bankruptcy remote device and the exposure to these risks: the more control or perceived control afforder the lender by the bankruptcy remote device, the greater the likelihood that the lender will acquire obligations to third parties.

Apart from lender liability, there is always the risk that the bankruptcy structure may not prevent a borrower's voluntary bankruptcy or that a court will not enforce some or all features of a bankruptcy remote structure. A properly crafted, enforced bankruptcy remote structure can prevent a borrower or its parent from filing a voluntary bankruptcy petition on behalf of the borrower. Nevertheless, a bankruptcy remote structure may not prevent the borrower from being pulled into the bankruptcy of an affiliate in a bankruptcy "consolidation." A bankruptcy court may ignore the independent existence of a parent and its subsidiary or affiliates, collapse the independent structure and consolidate all of the entities into one bankruptcy proceeding. A bankruptcy court considering a consolidation applies a test similar to a traditional corporate "alter ego" test, including whether the entities maintain the formalities of separate identities (separate books, directors, officers) and whether each entity is adequately capitalized. The risk of a consolidation may be minimized by ensuring that the formalities of independence are maintained by all entities and, if warranted, expanding the scope of the bankruptcy remote structure to include risky affiliates.

The enforceability of bankruptcy remote structures remains uncertain. Although there is no legal reason to suggest that a properly crafted bankruptcy remote structure is not enforceable, as a matter of equity and public policy a bankruptcy court may refuse to recognize a structure that effectively prohibits bankruptcy. Until the courts have considered these issues at appellate levels, a lender must recognize the potential risk despite the most impeccably crafted structures.

Finally, bankruptcy remote devices can be expensive to design and negotiate. For example, a voting trust arrangement involves the outside voting trustee and its counsel as additional parties with whom agreements must be reached. Borrowers dislike any intrusion by a lender into their operations and will often strongly resist any bankruptcy remote device that provides the lender with control rights. For this reason, the parties should discuss the form and extent of the proposed bankruptcy remote structure early and should address these considerations in the term sheet or commitment letter to avoid costs and delays before closing. Also, because of the cost, the size of the transaction will often dictate the extent and complexity of the bankruptcy remote structure.


Lenders considering workouts of existing loans or advancing highly leveraged new financing should consider including some form of bankruptcy remote device in the transaction to reduce the bankruptcy risks inherent in these transactions. The appropriate bankruptcy remote options depends largely on the circumstances of the particular transaction. In any event, the use of bankruptcy remote devices provides no guarantees to a lender against a borrower's bankruptcy, but rather a tool to minimize the risk. And these structures may come with a price for the lender in liability exposure. Nevertheless, as courts begin to consider their enforceability, bankruptcy remote devices will increasingly become part of real estate financing transactions.

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